Risk, Financing and the Optimal Number of Suppliers

We study how supply risk, fixed supplier costs, financial constraints, and the dual role played by the suppliers as the providers of parts and the financiers of the manufacturer affect the relationship among firms in a supply chain, supplier selection, and supply chain performance. Using a one-period model, we consider joint procurement and financing decisions of a firm with limited financial capital, facing either an uncertain demand or an uncertain supply. We find that the optimal financing decisions are consistent with the financial “pecking order” theory and we characterize the optimal operational decisions. Our analysis suggests that the alternative financing sources (bank loans and trade credit) are complementary and that the firm uses more suppliers if the bank financing is not available. Surprisingly, we also find that the limit on the supplier loans and the wholesale price affect the optimal number of suppliers in a non-monotone way. By considering tradeoffs between the expected profit and the value of the option to default, we explain the effects of supply uncertainty on the shareholders’ value and the optimal decisions. Finally, we address the question of whether the firms operating in the developing economies should contract with more suppliers than the firms operating in the developed economies. The answer is “no”, if the fixed cost of an extra supplier is high. However, financial constraints will force firms in the developing economies to the suboptimal level of production and cause higher stock-out rates.